MBIA could be on the hook in Royal Indemnity case

MBIA Insurance Corp. may still have to pay some insurance claims on ABS deals it wrapped for now-bankrupt student loan lender Student Finance Corp. after hundreds of millions of dollars of that company's student loans defaulted as a result of alleged fraud.

In an opinion by the U.S. Court of Appeals for the Third Circuit, a judge found that the insurance company that insured Student Finance Corp.'s student loans, American International Group unit Royal Indemnity, might be freed from its obligation to pay a portion of those losses. If so, the remaining losses would have to be covered by MBIA. However, an attorney for MBIA feels the amount of the company's exposure will be minimal and possibly nil.

The case revolves around contracts written by Royal Indemnity Corp that insured Student Finance Corp.'s student loans in order to make them suitable for securitization. The contracts obligated Royal Indemnity to pay for any losses with respect to student loans insured by the company, and essentially waived the company's right to defend against any claims, even in instances of fraud.

It was later exposed that Student Finance Corp. allegedly gained Royal Indemnity's insurance policy fraudulently on the loans it originated. Royal Indemnity alleges Student Finance C orp. misrepresented the creditworthiness and employment history of its borrowers and conspired with schools to generate as many loans as possible by altering or forging loan documents, according to the opinion. As some loans went into default, Student Finance Corp. allegedly paid some of them down by diverting the proceeds of later loans, masking the default rates of older loans and convincing Royal Indemnity to insure more of them. Royal alleges that some of the proceeds were also diverted to the personal account of Student Finance Corp.'s then-CEO. Student Finance Corp. went bankrupt in 2002.

In 2004, the U.S. District Court for the District of Delaware found that Royal Indemnity's contracts were valid and that the company was obligated to pay over $282 million in losses incurred on the defaulted loans. The court found that Royal Indemnity's contracts "unambiguously waived fraud in the inducement as a defense to payment," according to the opinion. Royal Indemnity appealed that decision to the Third Circuit Court of Appeals, and, as a result of that court's decision, may be off the hook for certain portions of the $282 million.

The opinion states that Royal Indemnity should have to pay for losses incurred as a result of Student Finance Corp. using money from new loans to pay down defaulted loans. However, the opinion says Royal Indemnity should not have to pay for losses incurred when student loan borrowers actually paid Student Finance Corp., but the former CEO then allegedly diverted the funds. Stephen Obus, with MBIA counsel Proskauer Rose in New York, believes any amount found diverted by Student Finance Corp. will be small, and said there may not be any of those funds at all. "We haven't seen any evidence of that," said Obus.

Royal Indemnity is now filing a petition for a re-hearing of its appeal before the Circuit Court. It is unusual for the Circuit Court to change its mind on such a decision, and that if the petition is rejected, a trial court will determine the next step in the case. That could include discovery of information relating to Student Finance Corp.'s alleged diversion of funds.